Backdated economic value added

The term "Backdated Economic Value Added" is not a recognized or standard financial metric. It appears to be a conflation of two distinct concepts: "Economic Value Added (EVA)," which is a legitimate financial performance measure, and "backdating," which is a practice primarily associated with dating documents or transactions to an earlier time, often with legal and ethical implications, particularly in the context of stock options. This article will focus on defining and explaining Economic Value Added (EVA) and will then address the issues surrounding backdating as a separate, problematic practice in finance.

What Is Economic Value Added (EVA)?

Economic Value Added (EVA) is a financial performance measurement that aims to capture a company's true economic profit. It represents the value a company generates in excess of the required return on its invested capital⁵², ⁵³. As a concept within financial performance measurement, EVA goes beyond traditional accounting profit by explicitly considering the cost of all capital employed, including both debt and equity. A positive EVA indicates that a company is creating wealth for its shareholders, while a negative EVA suggests that it is destroying value by not generating sufficient returns to cover its capital costs⁵⁰, ⁵¹.

History and Origin

The concept of Economic Value Added was developed and popularized by the management consulting firm Stern Stewart & Co. (now Stern Value Management) in the early 1990s⁴⁷, ⁴⁸, ⁴⁹. While the underlying principles of economic profit and residual income have roots extending back over two centuries, Stern Stewart trademarked and commercialized EVA as a practical framework for corporate performance measurement and value-based management⁴⁴, ⁴⁵, ⁴⁶. The firm formally launched EVA in 1982, building upon earlier work in finance regarding the determinants of value⁴³. Companies like The Coca-Cola Company and Briggs & Stratton adopted EVA in the late 1980s and early 1990s as a system to align management incentives with shareholder wealth creation⁴².

Key Takeaways

• EVA is a measure of a company's true economic profit, deducting the cost of capital from its operating profit.
• A positive EVA indicates wealth creation for shareholders, meaning the company is earning more than its cost of funding.
• The metric was popularized by Stern Stewart & Co. and aims to overcome limitations of traditional accounting measures.
• EVA encourages managers to make decisions that generate returns exceeding the cost of capital.
• It is particularly suited for asset-rich companies where capital utilization is a significant driver of value.

Formula and Calculation

The formula for Economic Value Added (EVA) is calculated by subtracting the capital charge from the Net Operating Profit After Tax (NOPAT). The capital charge represents the minimum return required by investors on the capital they have invested in the business⁴¹.

The formula is:

Where:

• NOPAT (Net Operating Profit After Tax): This is the company's operating profit after accounting for taxes, but before any financing costs. It focuses purely on the profitability of core business activities³⁹, ⁴⁰.
• Invested Capital: This represents the total amount of capital employed in the business, including both debt and equity³⁸. It can be calculated as total assets minus current liabilities not bearing interest³⁷.
• WACC (Weighted Average Cost of Capital): This is the average rate of return a company expects to pay its investors for providing funds, considering the proportion of debt and equity in its capital structure³⁶. The WACC reflects the company's overall cost of capital.

The term ((Invested\ Capital \times WACC)) is often referred to as the "capital charge" or "finance charge"³⁴, ³⁵.

Interpreting the Economic Value Added

Interpreting Economic Value Added involves assessing whether a company is generating returns above and beyond its cost of capital. A positive EVA signifies that the company has successfully created value for its shareholders, as its operating profits exceed the minimum return required by its investors³², ³³. This indicates efficient use of capital and sound investment decisions.

Conversely, a negative EVA suggests that the company is destroying value, as its operating profits are not sufficient to cover the cost of the capital employed³¹. While a negative EVA might signal underperformance, it doesn't necessarily mean the company is unprofitable from an accounting standpoint; it simply indicates that the return is less than what investors could earn elsewhere for a comparable level of risk, or less than the company's cost of financing. Analysts often look at trends in EVA over time, as a rising EVA, even if still negative, can indicate improving value creation³⁰. It's crucial to compare EVA results across companies within the same industry and consider the business cycle position to provide proper context²⁸, ²⁹.

Hypothetical Example

Let's consider a hypothetical company, "GreenTech Solutions," that manufactures sustainable energy products.

In the last fiscal year:

• Net Operating Profit After Tax (NOPAT) = $5,000,000
• Total Invested Capital = $40,000,000
• Weighted Average Cost of Capital (WACC) = 10%

To calculate GreenTech Solutions' EVA:

1. Calculate the Capital Charge:
   Capital Charge = Invested Capital (\times) WACC
   Capital Charge = $40,000,000 (\times) 0.10 = $4,000,000

2. Calculate EVA:
   EVA = NOPAT - Capital Charge
   EVA = $5,000,000 - $4,000,000 = $1,000,000

In this example, GreenTech Solutions has an EVA of $1,000,000. This positive EVA indicates that the company generated $1 million in economic profit above the cost of the capital it employed. This suggests that GreenTech Solutions is effectively utilizing its assets to create shareholder value.

Practical Applications

Economic Value Added (EVA) is widely used across various aspects of corporate finance and investment analysis to foster value creation and improve decision-making.

• Performance Measurement: Companies use EVA to evaluate the financial performance of the entire organization, individual business units, or specific projects²⁶, ²⁷. It helps to identify which parts of the business are generating value above their cost of capital and which are not²⁵. This provides a more comprehensive view of profitability than traditional metrics like net income.
• Capital Allocation: By focusing on value creation, EVA guides decisions related to capital budgeting and investment opportunities. Projects with a positive expected EVA are generally prioritized as they are anticipated to generate returns higher than the cost of funding²⁴. This aligns investment decisions with the objective of maximizing shareholder wealth.
• Incentive Compensation: Many companies link management bonuses and incentive plans to EVA targets²², ²³. This encourages managers at all levels to make operational and strategic decisions that directly contribute to increasing shareholder value, creating a strong alignment between management's actions and investor interests²¹.
• Strategic Planning: EVA can inform strategic planning by highlighting areas of the business that are either inefficient in their use of capital or have high potential for value creation. This allows for better resource allocation and strategic adjustments²⁰.

For instance, companies like General Electric (GE) and Pfizer have historically utilized EVA as a key metric for evaluating business units and making strategic decisions, aiming to identify value-creating activities and improve performance¹⁹.

Limitations and Criticisms

While Economic Value Added (EVA) offers a robust framework for assessing value creation, it also has several limitations and criticisms:

• Reliance on Accounting Data and Adjustments: EVA is derived from accounting data, which can be influenced by various accounting policies, assumptions, and estimates (e.g., depreciation methods, inventory valuation)¹⁷, ¹⁸. To arrive at an "economic" profit, significant adjustments to GAAP (Generally Accepted Accounting Principles) figures are often required, which can be complex, subjective, and time-consuming. Inaccurate data or inappropriate adjustments can distort the calculated EVA¹⁶.
• Sensitivity to Cost of Capital Estimation: The calculation of EVA heavily relies on the Weighted Average Cost of Capital (WACC), which itself involves assumptions about market conditions, risk premiums, and the company's capital structure¹⁵. Small changes in the estimated WACC can significantly impact the resulting EVA, making it difficult to compare performance consistently across companies or over long periods¹⁴.
• Focus on Tangible Assets: EVA primarily considers the book value of invested capital, which often reflects tangible assets. It may not fully capture the value of intangible assets such as brand equity, intellectual property, customer loyalty, or human capital, which can be significant drivers of long-term competitive advantage and growth for modern businesses¹², ¹³.
• Short-Term Bias: Despite its aim to promote long-term value creation, managers may still prioritize short-term EVA improvements (e.g., cost-cutting or delaying strategic investments) to meet quarterly or annual targets, potentially at the expense of long-term growth and innovation¹¹. EVA is a historical measure, reflecting past performance, and does not inherently predict future potential¹⁰.
• Difficulty for Comparison: While EVA can be used for comparisons within a company, comparing EVA across different industries or companies with vastly different capital structures can be challenging due to varying capital intensity and risk profiles.

The Issue of Backdating

The term "backdated Economic Value Added" as a financial metric is not recognized, and it is important to distinguish this from the problematic practice of "backdating" financial documents, particularly stock options. Backdating involves falsely marking a document or agreement with an earlier date than when it was actually executed. In the context of stock options, executives might retroactively choose a grant date when the company's stock price was lower, thereby making the options "in-the-money" (immediately profitable) at the time of the actual grant.

This practice has been widely condemned and led to significant scandals in the mid-2000s, resulting in numerous investigations, executive resignations, and financial penalties by regulatory bodies like the U.S. Securities and Exchange Commission (SEC)⁹. For example, the SEC brought charges against companies like Research In Motion Ltd. (now BlackBerry Limited) and its executives for backdating millions of stock options⁸. Backdating can misrepresent executive compensation, mislead investors about a company's financial health, and violate accounting rules and tax laws⁷. It is generally considered an unethical and often illegal practice when used to manipulate financial reporting or benefit executives fraudulently.

Economic Value Added vs. Accounting Profit

Economic Value Added (EVA) and accounting profit are both measures of a company's financial performance, but they differ fundamentally in what they account for.

The primary distinction is that EVA goes a step further than accounting profit by imposing a charge for the use of all capital, not just debt. Accounting profit, such as net income, reflects a company's profitability after all operating expenses, interest, and taxes are deducted, but it does not subtract a cost for the equity capital provided by shareholders. EVA, therefore, provides a more comprehensive view of whether a company is truly generating value beyond the minimum return expected by all its investors, making it a measure of "economic profit"⁴.

FAQs

What does a positive Economic Value Added (EVA) indicate?

A positive Economic Value Added (EVA) indicates that a company is generating more profit than the cost of the capital invested in its operations³. This means the company is creating wealth for its shareholders and is efficiently utilizing its resources.

Why is Economic Value Added considered different from traditional accounting profits?

EVA differs from traditional accounting profits because it explicitly subtracts the cost of all capital (both debt and equity) from the company's net operating profit after tax. Traditional accounting profits, like net income, only account for explicit expenses, including interest on debt, but not the implicit cost of equity capital. This makes EVA a more comprehensive measure of true economic value creation.

Can Economic Value Added be negative? What does it mean?

Yes, Economic Value Added can be negative. A negative EVA means that the company is not generating enough profit to cover its total cost of capital, implying that it is destroying shareholder value². This does not necessarily mean the company is losing money in an accounting sense, but rather that it is not generating returns above the minimum required by its investors.

Is "Backdated Economic Value Added" a legitimate financial term?

No, "Backdated Economic Value Added" is not a legitimate or recognized financial term. The concept of "backdating" refers to the practice of falsely dating documents or transactions to an earlier time, which can have severe legal and ethical consequences, particularly in financial contexts like stock options.

How can a company improve its Economic Value Added?

A company can improve its Economic Value Added by increasing its Net Operating Profit After Tax (NOPAT) without proportionately increasing invested capital, reducing its Weighted Average Cost of Capital (WACC), or divesting from assets that are not generating sufficient returns to cover their cost of capital¹. This involves strategic decisions aimed at enhancing operational efficiency, optimizing capital structure, and making profitable investments.